Why Long-Dated Treasuries Are Out Of Step With Economic Data

By Michael Aneiro

Bank of America Merrill Lynch‘s rates strategy team today examines the somewhat odd behavior of various parts of the Treasury yield curve on days that produce upbeat economic data. The front end of the yield curve – shorter-maturity Treasuries – has seen yields rise (and prices drop) on such days, which makes sense, but longer-maturity Treasury yields have fallen, which isn’t what you’d expect. Here’s BofA offering an explanation:

The front end of the market has demonstrated intuitive price action this year – rising on better than expected economic data. Chart 1 illustrates the cumulative sum of changes in yields this year, on days when the data surprise index moves higher. As expected, better data days were met with front-end yields moving higher. Counterintuitively, long end yields declined significantly on those very days.

Bank of America Merrill Lynch

One possible explanation for such a move could be that the market is pricing in a policy mistake: being ahead of the curve in terms of tightening, which could hurt long-term growth and inflation expectations. However, in this case we would have not expected risky assets to perform well. In addition, inflation expectations have been stable if not rising in recent months. Therefore, we are more inclined to believe that the decline in long end rates has been driven by price insensitive buyers of duration. Only when this duration need has been met, can long end rates reflect fundamentals. We continue to monitor reserve accumulation, capital inflows as well as market response to data to gauge the magnitude of this demand going forward.

As the Fed backs off its quantitative easing program, Bof A says the front end of the yield curve “will become singularly focused on the Fed’s reaction function. Ultimately, incoming data will drive the front end of the curve, but the extent will be determined by the market’s interpretation of what it means for Fed policy.”

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